Thursday, December 1, 2011

Rejecting FairTax Part Three: The Flat Income Tax

In Part One, I'll cover the dangers of taxing consumption as a major source of government revenue, both to the individual and to the economy.

Part Two will cover the little-known problems in the FairTax proposal- the "fine print" FairTax advocates won't tell you about (or don't know themselves); I'll also refute some of the inconsistencies and rhetoric used by FairTax advocates.

Part Three will introduce the reader to the benefits of flat income taxation- why it's superior to consumption tax, and the economic benefits of flattening the tax code.

Part Four will introduce the reader to the Negative Income Tax Credit- an ideal solution to the the problems of our massive welfare state, which can only be implemented in conjunction with an income tax system.

Part Three: The Flat Income Tax

I can't think of a better introduction to the Flat Tax than the one given by Steve Forbes:
The flat tax would be simple. You could fill it out on a postcard. It would be honest. It would eliminate the principal source of political corruption in Washington. It would be fair. There would be no tax on Social Security. No tax on pensions. No tax on personal savings. It would zero out capital gains taxes. It would set off a boom by letting people keep more of what they earn and by lowering barriers to risk taking.
For a more-complete introduction, I highly recommend "The Flat Tax" (which can be bought in e-book format from that link for $6.72), written by the originators of the modern flat income tax concept, Robert Hall and Alvin Rabushka.

Let's tick through each of Steve's points:

The flat tax would be simple. One thing which is not generally understood about our tax code: The majority of its 70,000+ pages are devoted to defining what "income" is, and in what manner said income is taxed. This is also the source of many "loopholes" in the tax code. Treating all income identically for tax purposes would eliminate the bulk of the tax code, making it simple enough that a tax return would be the size of a postcard.

It would eliminate the principal source of political corruption in Washington. Indeed, Forbes is right- the principal source of corruption in Washington is from tax lobbyists. It is they who are responsible for the extent of our tax code, and the special "carve-outs" given to selected businesses and industries. The ability to undo decades of their influence with a single pen stroke- to make the tax code both honest and fair- is highly attractive.

There would be no tax on Social Security. No tax on pensions. This is a major selling point for the flat income tax over consumption taxes. As I illustrated in Part One, a national consumption tax would eliminate the tax privilege for retirees' Social Security and/or personal retirement savings. Flat income tax would retain this tax-privileged status.

No tax on personal savings. It would zero out capital gains taxes. One of the few substantive selling points of FairTax is the fact that a consumption tax wouldn't tax investment and savings. However, this effect can be duplicated in a flat income tax by simply eliminating the capital gains tax and granting a deduction for personal savings, without exposing taxpayers to the negative consequences of a consumption tax. In the link above, Forbes mentions "pushing millions of people out of the tax system"- this is a reference to the elimination of capital gains tax.

It would set off a boom by letting people keep more of what they earn and by lowering barriers to risk taking. As I illustrated in Part One, consumption taxes are regressive- they keep poor people poor. Consumption taxes also favor already-established large businesses over new, small businesses. A flat income tax, on the other hand, is non-regressive and non-favoritist. It promotes economic competition rather than stifling it. All business pay the same rate on their profits, and all individuals pay the same rate on their incomes.

I'll add another point: It would eliminate the corporate income tax. Corporate income tax, like capital gains tax, is a "double-tax": Corporations are bodies of people (shareholders), and the profits after business expenses belong to them. This means the same money is taxed twice- once under corporate income tax, and then again under personal income tax (when they sell their shares) or capital gains tax (when their shares grow in value). In fact, in most cases it's a "triple-tax", since the shares were initially purchased with money on which personal income tax had already been paid. This tax is also crippling: our corporate rate is the second-highest in the world (35%), yet it only accounts for 9% of total federal revenues.

As for eliminating deductions: While most deductions can be safely eliminated without great controversy, there is one which must be specifically addressed: Charitable contributions.

Naturally, the public at large believe that this deduction promotes altruistic contributions from "the wealthy" to legitimate charities. In fact, the reality of this deduction is somewhat different: Much of the money claimed in this deduction is donated to non-charitable organizations (political and quasi-political organizations, for example). Indeed, Robert Hall and Alvin Rabushka point out the following in their book (above):
There is little merit in public subsidy for organizations whose success in raising funds depends on tax deductibility rather than the intrinsic merits of their activities.
While it would be preferable to eliminate it entirely, for the reasons stated above, an acceptable compromise would to do what Hong Kong has done: Cap charitable contributions at a percentage of a person's taxable income.

On the other hand, a deduction which must be preserved is the deduction for business expenses- a very necessary deduction, since (as stated previously) taxing business expenses would create a barrier to entering self-employment, and would disproportionally burden small businesses in comparison to large businesses. Note that there are differing opinions on this deduction amongst flat tax advocates.

One more benefit of flat income tax over FairTax: Predictability. We have had, in this country, a federal income tax for nearly a century. Our economy, and individual taxpayers, are already accustomed to income taxation. Business tax compliance measures, individual and group retirement investments, financial planning services, and many aspects of long-term business decision-making (just to name a few things) are already oriented toward income taxation, and are ready to acclimate to flattening the tax code. Eliminating the income tax in favor of a brand new- and totally unproven- consumption tax system would generate a minefield of unforseeable and unintended consequences (in addition to the known consequences covered in Parts One and Two).

In sum: In comparison to consumptions taxes, flat income tax is simpler, fairer, more transparent, and decidedly less risky. Flat income tax is also a tried-and-true system: Unlike major consumption taxes, which have been a failure in countries which have adopted them, flat income tax has been a rousing success in those countries which have instituted it.

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